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INSIGHT: Comparing and Contrasting the Benefits of Qualified Opportunity Zones and 1031 Exchanges

May 1, 2019, 1:15 PM

A very popular story line going into 2019 was the stimulative benefit that qualified opportunity zones (QOZs) would have on the nation’s real estate market. The QOZ program is a part of President Trump’s tax reform, which was not finalized until the fall of 2018 and is one of the few aspects of tax reform that people find to be beneficial for the real estate market. It goes without question that QOZs have garnered a significant amount of interest in the real estate market, but it remains to be seen how beneficial this program will be.

Many in the real estate industry came into 2019 very optimistic in terms of the benefit this program would provide to the real estate market, and, as we just closed out Q1 of 2019, I am surprised how few deals closed under the purview of a QOZ in New York City.

Any tax deferral mechanism is something that would spark interest amongst the real estate community. QOZs are certainly intriguing, but the lack of clear guidance has resulted in many questions left unanswered for potential investors. One cannot help but analyze whether the QOZ program is better for the marketplace than the tax code Section 1031 tax deferred exchange. If you recall correctly, the Trump administration had originally contemplated eliminating the 1031 exchange in its entirety at one point prior to tax reform being finalized but opted to maintain the program for the real estate asset class.

A 1031 tax deferred exchange is limited to the exchange of real estate investment property for real estate investment property (also property held for productive use in trade or business). A QOZ differs in several important ways. It provides you with the ability to defer tax on gains on any investment one may have regardless of whether it is real estate, securities, a business, etc. (i.e. any investment that generates a capital gain). You can then use those proceeds to purchase a property in a QOZ.

The program is still tailored to increase investment in real estate but is significantly less restrictive given that the funds you can use can come from any capital gain and not one limited to real estate. Approved zones have been created in all 50 states, and there are currently 8,762 different zones throughout the country. In order to be approved as a “zone,” local politicians would select areas in their state that are in need of an injection of capital, job creation, and revitalization of real estate.

Eventually gains tax will be due on this investment, but the incentive for pursuing this is that you receive a stepped-up basis should you hold the investment for a certain period. If you hold the investment for at least five years, you then receive an increase of 10 percent in your original basis, and if you hold it for at least seven years, you receive an additional 5 percent in your basis. If the investment is held for at least 10 years, then the basis of the investment in the QOZ will be increased to the fair market value of the investment at the time it is sold. There will be no federal taxable gain on the appreciation of the investment in a QOZ if held for at least 10 years. The latter part is by far the most appealing aspect of this program.

There are two major concerns with a QOZ. The first is the 10-year hold period. The ultimate benefit is not the stepped-up basis on the gain of the initial asset you are selling; it is the fact that you can potentially pay zero gains tax on the appreciation of your real estate investment in a QOZ if you own that asset for 10 years or more. Many real estate investors look to improve properties, stabilize them, and have a quick exit strategy. The second issue is the substantial improvement requirement.

For example, if you were to acquire a property for $1 million, you would be required to spend the sum comparable to the value of the property minus the value of the land, in improvements for the property. If the building is worth $750,000 and the land is worth $250,000, you are required to spend $750,000 in improvements. The only asset classes that would be eligible would be vacant land that is being developed, buildings that essentially need to be torn down and rebuilt, or a distressed asset that needs a complete renovation.

Given the substantial improvement requirement, the parties who will benefit most from this program will likely be developers and institutional investors. Individual investors and small businesses would not be able to take advantage of the QOZ program in the same capacity. It is estimated that 30 percent of annual volume in commercial real estate transactions throughout the country are transacted using a 1031 exchange. Given the comparison between the two, I believe the 1031 exchange will remain the preferred mechanism for traditional real estate investors seeking a tax deferral.

Investors besides developers and institutions can benefit from the QOZ program if they look to become passive investors and invest their gains into a QOZ fund which is managed by a third party. The QOZ program certainly has its advantages, but the program will not be nearly as beneficial to the real estate market as the 1031 exchange has been since its inception close to a 100 years ago.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Pierre E. Debbas is a partner and founding member of Romer Debbas LLP. His practice focuses on the purchase and sale of commercial and residential real estate in New York City, commercial leasing, real estate related financing matters, representation of cooperative and condominium boards, foreign investors and small businesses.